Governance at private companies can be simple. But when stakeholder interests aren't aligned, a company begins to slide into the realm of independent directors and shareholder agreements
This month and next, we'll look at corporate governance in emerging private companies. Very little governance is prescribed for companies of this sort. Generally, they must have at least one director, and they must provide basic financial material to shareholders on an annual basis. An annual meeting is also required, although this can be satisfied in writing.
Additional governance, however, may be introduced by the wishes of one or more of the company principals, or it may be required as part of a financing. Often, this additional governance is represented by an agreement signed by all shareholders called a unanimous shareholders agreement (USA).
Although I am often asked for an "off-the-shelf" version of a USA, the nature of these agreements – their complexity, coverage and substance – should be tailored to the needs of the company. An agreement appropriate for the controlling shareholder of a sizeable company is unlikely to be well-suited to the needs of an earlierstage enterprise, for instance. Dealing with the specific requirements of the shareholders and the business help ensure that corporate governance is positive and constructive, rather than formalistic or unduly constraining.
Who's on First?
The most basic governance decision to be made in a USA is whether the company will be run primarily by its board or by its shareholders. In the latter case, the USA will provide that a significant number of corporate decisions require approval by a particular shareholder or shareholder class. Typical matters that might require the approval of the majority of preferred shareholders include: executive compensation; annual plans; unbudgeted and capital expenditures; borrowings; acquisitions; financings; mergers; initial public offerings; and related-party transactions.
The alternative is to establish a board of directors and leave these decisions to the board. A board of this sort would be composed of, say, two founder nominees, two investor nominees and one independent director approved by both. Significant matters would then simply be decided by the board generally, with no veto to the investor, and with "control" over corporate decisions effectively in the hands of the independent director. Even in this model, however, it is customary to reserve some decisions for approval by the investor, usually decisions affecting the nature of the investment itself rather than the business — for instance, the creation of classes of shares equal to or in priority to the investor's shares.
While the "director-driven" model involves ceding control to the board earlier than under the shareholder-control model, it affords the opportunity to introduce and get used to a functioning board, and it avoids the adversity and constraints of an investor-veto model.
How Do I Get Out?
USAs usually deal with a variety of issues around "liquidity." It is common to require that a liquidity event occur within five years — financial investors need to make and show a return, and are not in their deals for indefinite terms. Investors often reserve a right to require the company to purchase their holding at "fair market value" if a satisfactory IPO or other liquidity event (sale of the business) has not occurred.
Otherwise, USAs typically constrain individual shareholders' rights to liquidity. While usually permitting transfers to "controlled entities" to facilitate tax and family planning, USAs will generally not permit individual shareholders to sell shares. Restraints may be imposed to retain key executives, to avoid the compromising of confidentiality (if a competitor acquired shares, for example), or to avoid placing a market value on shares (which can be adverse to future funding intentions). On the other hand, some shareholders, and particularly purely financial investors, may require that they have the right to sell their stock, or even the entire business, in certain circumstances. Rights of the various parties in these situations are usually regulated in the USA through first right, tag-along and drag-along rights.
Next month, we'll look at how these rights work, and provide practical guidance about how USAs can be amended or terminated.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
